A $1 Trillion Pain Trade in Treasuries Divides Top Bond Dealers

(Bloomberg) -- To appreciate just how important the Federal Reserve has been to the U.S. Treasury, consider this simple fact: It alone financed roughly 40% of America's budget deficit last year.

So as Fed officials talk up the possibility of unwinding the central bank's crisis-era bond holdings later this year, figuring out what will happen when the U.S. loses its biggest source of funding has become a pressing concern.

Of course, finding ready buyers in the Treasury market — arguably the safest and most important in the world — has rarely been a problem. But with deficits poised to balloon, bond dealers are divided over which parts of the market will feel the most pain as the Fed pulls back and the Treasury ramps up debt issuance to fill those gaps. For JPMorgan Chase, five- to seven-year notes are the most vulnerable to weakening demand, while Deutsche Bank and Societe Generale say yields on longer-term Treasuries will rise the most.

"With the Fed, the Treasury has had a very steady backstop buyer of their debt," said Subadra Rajappa, SocGen's head of U.S. interest-rate strategy. In coming years, "the Fed has a lot of debt maturing, so there will be a lot more Treasury issuance as the Fed tapers reinvestments."

THE FED'S PULLBACK

Indeed, in the next three years, over a trillion dollars' worth of the Fed's $2.5 trillion stockpile of Treasuries — amassed over three rounds of quantitative easing — will come due. (The central bank also owns $1.77 trillion of mortgage-backed securities as a result of its QE program.) Last year, the Fed bought just enough Treasuries, about $216 billion worth, to replace those that matured and keep its balance sheet constant. But some dealers expect that reinvestment policy, in place since 2014, to change before year-end.

The consequences of the Fed's pullback extend well beyond the bond market. Rising borrowing costs would make it more expensive to pay for the Trump administration's pro-growth agenda, which includes not only a trillion dollars of infrastructure spending, but also sizable across-the-board tax cuts. That's not counting the additional $10 trillion of public debt the U.S. is already expected to incur over the next decade to pay for programs like Medicare and Social Security, according to the Congressional Budget Office.

A sustained jump in funding costs may also complicate the case for a new 50-year bond, which Treasury Secretary Steven Mnuchin and Gary Cohn, Trump's top economic adviser, have spoken publicly about in recent weeks.

"The timing of all this coming together is unfortunate for Treasury and the decision on debt issuance is going to be sort of a conundrum for them," said Boris Rjavinski, a strategist at Wells Fargo Securities.

According to Barclays, it all means that the Treasury may have to increase the amount of notes and bonds it sells at auction as much as 25% over the next two years. That assumes the share of T-bill supply stays stable and the deficit widens by about $150 billion over that span.

'THE FIRST PORT OF CALL'

Initially, most dealers say the Treasury will issue more bills once the Fed starts its unwind, partly to bolster dwindling supply. As a proportion of U.S. debt, bill supply plunged after the Fed cut interest rates to rock-bottom levels and the government took advantage to lock in long-term funding costs.

Bill issuance is "the first port of call," said George Goncalves, Nomura's head of fixed-income strategy. "We're at a point where we don't have a lot of short-term assets."

But eventually, the government should increase issuance across the board to lengthen the average maturity of its debt, according the Treasury Borrowing Advisory Committee. That will likely hit 30-year yields the hardest, TBAC said. According to its analysis, increasing auction supply by $4 billion a month for a year will lift 30-year yields as much as 0.18 percentage point.

Long bond yields were at 2.99% today.

"The biggest pain points off the increased issuance will be on the very long end" as potential buyers are far less diverse, said SocGen's Rajappa.

HIGH STAKES

Deutsche Bank says the Treasury should compensate for the Fed's unwind by using a barbell approach — increasing issuance of bills, two- and three-year notes on the short end, and 10- and 30-year bonds on the long end. That will cause a "mild steepening" of long-end yields.

Jay Barry, a fixed-income strategist at JPMorgan, sees it differently. While he expects the Treasury will follow TBAC's recommendation and boost auction sizes across maturities, the fact that the Fed will likely trim back Treasuries and mortgage-backed securities simultaneously means the boost in debt supply will probably have a larger impact on the middle of the curve. That, in turn, will cause yields in that part of the market to disproportionately increase.

Jefferies projects the auction size for the five-year Treasury note will rise to $50 billion by fiscal 2022 — when the CBO expects the deficit to approach $1 trillion — from $34 billion now. That's the most among coupon securities.

Whatever the case, the stakes are high. In a sign of just how high they are, former Fed Governor Kevin Warsh said this month the central bank — which has generally refrained from coordinating with the Treasury to maintain its independence — should do so when it starts trimming its assets.

"You've probably got a very aggressive fiscal stance by this administration. You've got the Federal Reserve looking to unwind its balance sheet," said Lou Crandall, the chief economist at Wrightson ICAP. As a result, "overall Treasury issuance has to rise a lot in the coming years."